THEORY OF COST

ECONOMIC COST
= is defined in terms of the cost of the foregone or
sacrificed alternative.
= It includes the accounting cost and the opportunity
cost/ implicit cost

ACCOUNTING COSTS
=also known as explicit costs, are costs that involve
money being spent. Examples include rent, interest payments
and utility bills
Costs are obligations made by the firm in its operations.

• EXPLICT COSTS= out-of-pocket or actual expenditures

made by the business firms. Usually, these are paid to the
non-owners of the firm and are recorded in the firm's financial
statements.

• IMPLICIT COSTS= these are costs of self-owned or

self-employed resources.

No actual monetary payments are usually made.

• Economic costs = Explicit + Implicit Costs
• Accounting costs = Explicit Costs only

COSTS IN RELATION TO THE BUSINESS FIRMS

OPERATIONS
= A. COSTS IN THE SHORT RUN
= B. COSTS IN THE LONG RUN
= Costs in the Short Run
= In the Cost Theory, there are two types of costs associated
with production - Fixed Costs and Variable Costs.
= In the short-run, at least one factor of production is fixed, so
firms face both fixed and variable costs. The shape of the cost
curves in the short run reflect the law of diminishing returns.
Economies of Scales:
• MAIN COSTS IN THE SR • Economies of Scale is defined as a fall in the long run
• 1. Total Cost = Fixed Cost + Variable Cost average costs because of an increased scale of
production. This basically means the cost of production
per unit reduces as you produce more units. Reducing
the cost per unit of production is the most significant
advantage of achieving economies of scale.

Examples of Internal Economies of Scale

• 1. Technology
• 2. Buying Power
• 3. Financial or capacity of big firms in acquiring credit
When the output is zero, variable costs are also zero. But
we have fixed costs which is where the Total Costs start. The
Total Cost remains parallel to the Variable Cost, and the Examples of External Economies of Scale
distance between the two curves is the Fixed Cost. • 1. Transportation
• 2. Skilled Labor/ Specialization of labor
• 2. Variable Cost = Total Cost - Fixed Cost
Causes of Diseconomies of Scale
• 3. Fixed Cost = Total Cost - Variable Cost • 1. Workers: difficulty in managing large number of work
force
• 4 PER UNIT COSTS
• 2. Supply chain: difficulty in coordinating informations
• : these are main costs divided by quantity
• 1. Average cost = TC/Q across factories and countries.
• 2. Average Variable Cost =
VC/Q Examples of Diseconomies of Scale
• 3. Average Fixed Cost = FC/ Q • 1. Poor Communication: due to ineffective flow of
• 4. Marginal Cost = TC/AQ communications between departments/ divisions/ head
offices/ subsidiaries.
 • 2. Coordination: difficult to coordinate operations when
firms are large.
• 3. Management Inefficiency: the loss of management
efficiency that occurs when firms become large and
operate in uncompetitive markets.
This include overpaying for resources, such as paying
managers salaries higher than needed to secure their
services and excessive waste of resources.
• 4. Motivation: The low motivation of workers in large
MARKET STRUCTURES
firms results in lower productivity, as workers may feel 1. The number of firms (including the scale and extent of
they are just another cog in the machine.
foreign competition)
• 5. Principal-Agent Problem: This problem is caused
2. The market share of the largest firms (measured by the
because the size and complexity of most large firms
concentration ratio)
mean that their owners often have to delegate decision
3. The nature of costs (including the potential for firms to
making to appointed managers, which can lead to
inefficiencies. exploit economies of scale and also the presence of
6. Complacency: Some economists argue that with sunk costs which affects market contestability in the
large and uncompetitive markets, firms tend to become long term)
complacent because of their size. 4. The degree to which the industry is vertically integrated -
vertical integration explains the process by which
different stages in production and distribution of a
product are under the ownership and control of a single
enterprise. A good example of vertical integration is the
oil industry, where the major oil companies own the
rights to extract from oilfields, they run a fleet of
tankers, operate refineries and have control of sales at
their own filling stations.
5. The extent of product differentiation (which affects
cross-price elasticity of demand)
Long Run Cost and It's Types 6. The structure of buyers in the industry (including the
1. Long run Total Cost (LTC) refers to the minimum cost possibility of monopsony power)
at which given level of output can be produced. 7. The turnover of customers (sometimes known as
2. Long run Average Cost (LAC) is equal to long run total "market churn") - i.e. how many customers are prepared
costs divided by the level of output. to switch their supplier over a given time period when
3. Long run Marginal Cost (LMC) is defined as added market conditions change. The rate of customer churn
cost of producing an additional unit of a commodity is affected by the degree of consumer or brand loyalty
when all inputs are variable. and the influence of persuasive advertising and
marketing.
Long Run Average Cost Curve
All costs of a firm are variable. The factors of The Four Types of Market Structures
production can be used in varying proportions to deal 1. Perfect Competition
with an increased output. The firm having time-period describes a market structure, where a large number of
long enough can build larger scale or type of plant to small firms compete against each other. In this
produce the anticipated output. The shape of the long scenario, a single firm does not have any significant
run average cost curve is also U-shaped but is flatter market power. As a result, the industry as a whole
that the short run curve as is illustrated in the following produces the socially optimal level of output, because
diagram. none of the firms have the ability to influence market
prices.

Assumptions
• (1) Many "small" sellers
• (2) there is free entry and exit to the market,
• (3)ll firms sell completely identical (i.e. homogenous)
goods
(4) Firms are price takers and the industry is the price
maker
(5) No price and no non-price competition
Long run cost informations (6) Mobility of resources: switching from one production
Consider the following cost data line to another production line in order to minimize
• (3) firms sell differentiated products losses in the operation.
Monopolistic Competition
refers to a market structure, where a large number of
firms compete against each other.
However, unlike in perfect competition, the firms in
monopolistic competition sell similar, but slightly
differentiated products (Heterogenous products). This
gives them a certain degree of market ower which
allows them to charge higher prices within a certain
range.
Assumptions:
• (1) many "large" sellers
• (2) there is free entry and exit to the market
• TR=P*Q
• Profit
• Profit = Total Revenue - Total Cost
• P=TR-TC
Profit Maximization under Perfect Competition
• (4) consumers may prefer one product over the other
• Total Revenue
(5) There is price and non-price competition
• (6) Excess capacity: firms inputs are under utilized as • If Q is output of the firm, Total Revenue is :
they consider the production levels of the many • Total Revenue = Price x Quantity
competing firms in the industry. TR= PxQ
Profit
Oligopoly: Profit= Total Revenue+Total Cost
"oligo" literally means few and "poly" means sellers. p=TR+TC
a market structure which is dominated by only a small
number of firms. This results in a state of limited Approaches:
competition. The firms can either compete against each • 1. TOTAL APPROACH
other or collaborate. By doing so they can use their • Profit maximizing output = greatest positive difference
collective market power to drive up prices and earn between TR and TC.
more profit. • TR= P x Q
Assumptions: • TC= FC + VC
• (1) all firms maximize profits, • = ACxQ
(2) oligopolies can set prices,
• (3) there are barriers to entry and exit in the market,
• (4) products may be homogenous or differentiated,
• (5) there is only a few firms that dominate the market.

Monopoly:
"mono" means one and "poly" for seller.
a market structure where a single firm controls the
entire market. In this scenario, the firm has the highest
level of market power, as consumers do not have any
alternatives.
As a result, monopolists often reduce output to increase 2. MARGINAL APPROACH
prices and earn more profit. • Profit maximizing output= MR = MC
Assumptions: •МС = TC/ 4Q; MR = ATR/ AQ
• (1) the monopolist maximizes profit,
• (2) it can set the price,
(3) there are high barriers to entry and exit (which are
large amount of capital requirements, control of the
inputs used to manufacture unique goods or services,
operation has to be franchised and product has to be
patented.)
• (4) there is only one firm that dominates the entire
market.
• eg. ALCOA as monopoly and monopsony market
structure.
 profit-maximizing quantity to the demand curve shows
the profit-maximizing price. This price is above the
average cost curve, which shows that the firm is
earning profits.
Step 3: Calculate Total Revenue, Total Cost, and Profit
Total revenue is the overall shaded box, where the
Requirements: width of the box is the quantity being sold and the
1. using the total approach in maximizing profit, height is the price.
determine the profit maximizing output.
How much is the cost incurred in producing it? How COST AND REVENUE DATA OF A MONOPOLY
much is the revenue? What is the size of the profit? MARKET
2. If marginal approach is used, set up the relevant cost
and revenue data. Plot them on a graph and determine
the profit maximizing output, the total cost of producing
it, the total revenue generated and the size of the profit.

Regulations under monopoly

1. Price control: government to set the maximum price
on the basis of the equality between MC and the DD.
• effects:
• a. Reduction in the price
• b. Increase output production
• c. Reduction in the profit
• 2. Imposing per unit tax
• effects:
• a. Increase price as the burden of paying taxes is
passed on to the consumers in the form of a higher
price.
• b. Reduction the Qd
• c. Reduction in the profit
• d. affects MC
3. Imposition of a lump sum tax which is a tax collected
during the production cycle of the business firm. A tax
which cannot be passed on to the consumers.
• effects:
• a. no effect on MC
• b. no effects on price, quantity and revenue
• c. Profit is reduced by the amount of lump tax
collected .
• The profit-maximizing choice for the monopoly will
be to produce at the quantity where marginal revenue is
equal to marginal cost: that is, MR = MC. If the
monopoly produces a lower quantity, then MR > MC at
those levels of output, and the firm can make higher
profits by expanding output.

Three-step process where a monopolist:.

• Step 1: The Monopolist Determines Its Profit-Maximizing
Level of Output
The firm can use the points on the demand curve D to
calculate total revenue, and then, based on total
revenue, calculate its marginal revenue curve. The Choosing the Profit-Maximizing Output and Price
profit-maximizing The monopolistically competitive firm decides on its
quantity will occur where MR = MC-or at the last profit-maximizing quantity and price in much the same
possible point before marginal costs way as a monopolist. A monopolistic competitor, like a
start exceeding marginal revenue. monopolist, faces a downward-sloping demand curve,
• Step 2: The Monopolist Decides What Price to Charge
and so it will choose some combination of price and
• The monopolist will charge what the market is willing quantity along its perceived demand curve.
to pay. A dotted line drawn straight up from the
competitor, consider the Authentic Chinese Pizza store, • As an example of a profit-maximizing monopolistic
which serves pizza with cheese, sweet and sour sauce, A single firm (the leader) chooses an output before all
and your choice of vegetables and meats. Although other firms choose their outputs. All other firms (the
Authentic Chinese Pizza must compete against other followers) take as given the output of the leader and
pizza businesses and restaurants, it has a differentiated choose outputs that maximize profits given the leader's
product. The firm's perceived demand curve is output. Barriers to entry exist.
downward sloping, as shown in Figure 1 and the first 4. Bertrand Oligopoly Model
two columns of Table 1. Conditions for Bertrand Oligopoly:
• There are few firms in the market serving many
consumers. Firms produce identical products at a
constant marginal cost. Firms engage in price
competition and react optimally to prices charged by
competitors. Consumers have perfect information and
there are no transaction costs. Barriers to entry exist.

The conditions for a Bertrand oligopoly imply that

firms in this market will undercut one another to capture
the entire market leaving the rivals with no profit. All
consumers will purchase at the low-price firm. This
"price war" would come to an end when the price each
firm charged equaled marginal cost.
OLIGOPOLY MODELS: • Conclusion:
Conditions for Oligopoly • Different oligopoly scenarios give rise to different
Key ConditionsOligopoly market structures are optimal strategies and different outcomes. Your optimal
characterized by only a few firms, each of which is large price and output depends on ...
relative to the total industry. Typical number of firms is • A. Beliefs about the reactions of rivals.
between 2 and • B. Your choice variable (P or Q) and
10. Products can be identical or [Link] • C. the nature of the product market (differentiated or
oligopoly market composed of two firms is called a homogeneous products). Your ability to credibly commit
duopoly. Oligopoly settings tend to be the most difficult prior to your rivals.
to manage since managers must consider the likely
impact of his or her decisions on the decisions of other
firms in the market.
1. Sweezy Oligopoly Model Conditions for Sweezy
Oligopoly:
There are few firms in the market serving many
consumers. The firms produce differentiated products.
Each firm believes its rivals will cut their prices in
response to a price reduction but will not raise their
prices in response to a price increase. Barriers to entry
exist.
2. Cournot Oligopoly Model Conditions for Cournot
Oligopoly:
There are few firms in the market serving many
consumers. The firms produce either differentiated or
homogeneous products. Each firm believes rivals will
hold their output constant if it changes its output.
Barriers to entry exist.
Consider a Cournot duopoly. Each firm makes an output
decision under the belief that is rival will hold its output
constant when the other changes its output level.
Implication:
Each firm's marginal revenue is impacted by the other
firms output decision. The relationship between each
firm's profit-maximizing output level is called a
best-response or reaction function.
3. Stackelberg Oligopoly Model Conditions for Stackelberg
Oligopoly:
• There are few firms serving many consumers. Firms
produce either differentiated or homogeneous products.